Monday, November 8, 2010

The reaction to the Fed's QE2 program has come hot and fast. Emerging market authorities are complaining loudly about QE2. From Brazil to South Africa, the reaction has been swift and negative. China’s Vice-Foreign Minister Cui Tankai said that the US “owes us some explanation on their decision” and PBoC governor Zhou Xiaochuan complained that QE2 “is not necessarily optimal policy for the world”. In central banker-speak, that's somewhat akin to Emperor Hirohito's announcement to the Japanese people at the end of WW II "that the war has not necessary unfolded to our advantage.

Beyond the complaints, it will be telling to see how the capital exporters like the OPEC Gulf states and China react. QE2 will export asset inflation to China and push up the prices of real estate and rare antiques.

The critics come out of the woodwork
Beyond other governmental and central bank authorities, the critics have been out in force. Portfolio manager John Hussman was scathing in his criticism. Bernanke, Hussman believes, is blowing another asset bubble and repeating the mistakes that Greenspan made and this will end very badly [emphasis added]:

It is difficult to interpret Bernanke's defense of QE2 as anything else but an attempt to replace the recent bubble with yet another - to drive already overvalued risky assets to further overvaluation in hopes that consumers will view the "wealth" as permanent. The problem here is that unlike housing, which consumers had viewed as immune from major price declines, investors have observed two separate stock market plunges of over 50% each, within the past decade alone. While investors have obviously demonstrated an aptitude for ignoring risk over short periods of time, it is a simple fact that raising the price of a risky asset comes at the sacrifice of lower long-term returns, except when there is a proportional increase in the long-term stream cash flows that can be expected from the security.

As a result of Bernanke's actions, investors now own higher priced securities that can be expected to deliver commensurately lower long-term returns, leaving their lifetime "wealth" unaffected, but exposing them to enormous risk of price declines over the intermediate (2-5 year) horizon. This is not a basis on which consumers are likely to shift their spending patterns. What Bernanke doesn't seem to absorb is that stocks are nothing but a claim on a long-term stream of cash flows that investors expect to be delivered over time. Propping up the price of stocks changes the distribution of long-term investment returns, but it doesn't materially affect the cash flows. This reckless policy has done nothing but to promote further overvaluation of already overvalued assets. The current Shiller P/E above 22 has historically been associated with subsequent total returns in the S&P 500 of less than 5% annually, on average, over every investment horizon shorter than a decade.

Andy Xie believes that QE2 won't work to devalue the USD because "most major economies will do something to keep their currencies down":

The world seems full of smoke ahead of a world currency war. The weapon of choice is quantitative easing (QE). If you print a trillion, I'll print a trillion. No change in exchange rate after a trillion? Let's do it again, QE2.

Unintended consequences
Paradoxically, QE2 may have the opposite of depressing the US economy in a couple of ways. If China allows wages to rise and pass the costs along, it would raise the prices of consumer goods in the US. In addition, Andy Xie thinks that the RMB is overvalued:

I think China's currency is overvalued. China's money supply has exploded in the past decade, rising from RMB 12 to 70 trillion. Every currency has experienced depreciation after a pronged bout of money growth. China's industry has risen tremendously to justify part of the growth. However, a massive amount is in the overvalued property market. When it normalizes, the money flows out and the currency depreciation pressure happens. We should see this within two years.

As well, QE2 is pushing up commodity prices, which include food, which is depressing the American consumer's already weakened spending power. (Oh I forgot, central bankers look at inflation ex-food and energy, which is where the inflation is, so therefore there won't be any inflationary effect...)

Michael Panzner posted a graph showing the disconnect between Wall Street and Main Street, in the form of the stock market and US consumer confidence. Notice how they tracked each other until the Lehman Crisis, when the market took off but consumer confidence stayed flat.

QE2 is likely to increase that gap by rewarding the holders of capital by blowing another asset bubble while the suppliers of labor have to suffer the consequences of higher food costs and possibly higher prices of consumer goods made in China.

Recall that even the worse days of the Weimar Republic hyper-inflation, there were clear winners and losers. All that stimulus meant a roaring stock market, which rewarded the holders of capital, while the ordinary working people suffered. We know how that story ended.

It may not come to a repeat of the German experience, but the risks are there. Barry Ritholz points out that already, affluent Americans are more confident now than 2009. I also suggested before that QE2 has the potential to ignite class warfare.

1 comment:

When Sarah Palin calls for a cease and desist, and actually has better arguments than the central banker, you know something's gone seriously wrong with the Fed. I vote for central banker Palin, and a gold watch for Bernanke.

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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